The Riksbank, emergency finance, policy experimentation, and Sweden’s reversal of fortune

Journal of Economic Behavior and Organization 171 (2020) 312–332

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The Riksbank, emergency finance, policy experimentation, and Sweden’s reversal of fortune Joshua R. Hendrickson Department of Economics, University of Mississippi, 229 North Hall, University, MS 38677, United States

a r t i c l e

i n f o

Article history: Received 24 September 2018 Revised 20 December 2019 Accepted 2 January 2020

JEL classification: E58 N13 N43 Keywords: Sweden Frihetstiden Riksbank Central banking Commodity money War finance Mercantilism Inflation Quantity theory

a b s t r a c t At the beginning of the 18th century, Sweden was an imperial power that had just sustained a century of modest economic growth. In 1800, Sweden’s empire was gone, after a series of military defeats. Real GDP per capita had fallen to the same level as the early 1600s. In other words, the 18th century witnessed the end of the Swedish Empire and a startling reversal of economic progress. In this paper, I propose a possible explanation for both of these outcomes. First, I argue that Sweden’s limited fiscal capacity played an important role. The creation of the Riksbank should have facilitated government borrowing and military spending as the Bank of England did for the British. However, the Riksbank was not designed or equipped for this role. I document the constraints on financing national defense through the Riksbank and argue that the bank was ill-equipped to finance an adequate national defense. This explains the reversal of the empire. Second, when the Hats took power in the Riksdag in 1739, they used the Riksbank to give loans to firms, which were financed through the issuance of bank notes. The objective was to increase investment and economic activity. I find no evidence that these loans had any effect on real GDP per capita. However, the resulting inflation has a negative and significant effect on output during the period of inconvertible paper money. The combined evidence suggests that Hat policy contributed to the decline in economic activity during the reversal of fortune. © 2020 Elsevier B.V. All rights reserved.

“Of the years between 1720 and 1815 it might be said that everything was tried and nothing achieved.” – Heckscher (1954, p. 207)

1. Introduction At the beginning of the 18th century, Sweden was an imperial power and had experienced sustained economic growth for a century (Fouquet and Broadberry, 2015). By 1800, Sweden’s real GDP per capita was not only lower than it was in 1700, but it was approximately equal to what it had been in 1608, as shown in Fig. 1. In this respect, Sweden was an example

E-mail address: [email protected] https://doi.org/10.1016/j.jebo.2020.01.001 0167-2681/© 2020 Elsevier B.V. All rights reserved.

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Fig. 1. Swedish Real GDP per capita (in 1990 Geary-Khamis dollars), 160 0–180 0. Source: Schön and Krantz, 2012 and Fouquet and Broadberry (2015).

of modest growth episodes that resulted in subsequent reversals in the pre-industrialized world (Fouquet and Broadberry, 2015).1 In 1800, Sweden was also no longer an imperial power. What can explain this reversal of fortune? In this paper I present an attempt at an explanation that casts the Riksbank in a central role.2 Modern discussions of central banks are often limited to debates about rules versus discretion, analysis of alternative rules, or debates about the effectiveness of monetary policy. Historically, however, central banks have been the source of large scale experimentation. This is particularly true of the world’s oldest central bank, the Riksbank, and its precursor, Stockholm’s Banco. During the 17th and 18th centuries, Sweden’s central bank was used to finance war expenditures. During a period of the 18th century the Hat Party that controlled the Swedish legislature, the Riksdag, used the bank to lend to private firms in an attempt to promote economic activity. In this paper, I argue that the reversal of fortune in terms of military power and land holdings can be explained by government borrowing constraints that resulted from the legal and political limitations on the Riksbank. In addition, I argue that the experimentation with using the Riksbank as a tool of promoting economic activity through lending was not only unsuccessful, but seems to have actually led to a reduction in real GDP per capita. With regards to military success, the significant role of the Riksbank calls into question whether or not the bank was able to be a source of adequate financing. The ability of a central bank to be a sufficient source of emergency finance depends on its ability to expand its balance sheet in real terms during an emergency, such as a war. Whether or not a central bank can expand its balance sheet in real terms depends on the monetary regime and the legal and political restrictions placed on the bank. During the 18th century, Sweden fought in 3 wars: the Great Northern War, the Hats’ Russian War, and the Pomeranian War. The monetary regime and the restrictions of the Riksbank differed across regimes. However, I show that there is evidence that the government faced a binding borrowing constraint in each of the wars as a result of the restrictions (or lack thereof) on the Riksbank. The binding government borrowing constraint during the Great Northern War is perhaps the most important. I show that the there is evidence that the government borrowing constraint was binding shortly before the Battle of Poltava in 1709. Prior to this battle, Sweden had been quite successful. However, the Battle of Poltava marked the turning point in the war because it was during this battle that Sweden suffered a decisive and devastating military defeat from which they were unable to recover. The military defeat was due, in large part, to the inadequate supplies of the Swedish army. The supply shortages were known shortly before the battle and the king, Karl XII, had requested additional funding, but the Riksbank informed him that they were unable to meet his request. The defeat was followed by unsuccessful attempts on the part of the king to obtain a sufficient alternative means of financing. The binding constraint appears to be the cause of Sweden’s defeat and, given subsequent failures, the decline of its empire. In subsequent wars, while there is not the same clear-cut evidence that government borrowing constraints were to blame for the defeat, there is evidence that the government had reached a binding borrowing constraint in each of the latter two wars. So even if circumstances had been different, the evidence suggests that Sweden would not have been able to continue to finance an open-ended conflict. As a result, while the binding borrowing constraints might not be the cause-in-fact, the constraints might be a proximate cause of Sweden’s inability to reacquire the land holdings lost during the Great Northern War. With regards to the economic reversal, the experiments with using the bank to increase economic activity were also unsuccessful. After the death of King Karl XII, the Riksdag convinced the king’s sister to cede a great deal of political control

1 Note here that growth was somewhat modest since it took the economy nearly a century to double in size. Since the scale of the vertical axis does not begin at zero, it might not perfectly convey the modest nature of growth. 2 During this time, the bank was known as the Riksens Standers Bank, or “Bank of the Estates of the Realm.” Since 1866, it has been known as Sveriges Riksbank (Fregert, 2018). Throughout the paper, I will refer to the bank by its (abbreviated) current name.

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to the Riksdag in exchange for recognizing her as the heir to the throne. During the subsequent period from 1720 to 1772, political power was concentrated in the Riksdag. The Hat Party that controlled the Riksdag from 1739 to 1765 were mercantilists. It was their view that loans to private industry as well as ensuring an adequate supply of money was crucial to economic development. As a result, the Hats used the Riksbank to extend credit to private industry. The Riksbank financed these loans through the creation of bank notes. The Hats’ Russian War led to the abolishment of the convertibility of bank notes and the note issuance associated with private lending was unconstrained beginning in 1745. What followed is a signifiant period of inflation. I find no evidence that this lending had any effect on aggregate economic activity. In addition, I find that inflation is associated with dynamic reductions in real GDP per capita. Given the substantial inflation observed during this period, this suggests that the Hats’ mercantilist policies are a significant source of the reversal of economic fortunes. While my focus is on Sweden, there are broader themes contained within the paper. The first is the role of early central banks in facilitating large-scale emergency military expenditures. Some have argued that military and defense expenditures have been a primary source of financial innovation (Ferguson, 2001). Examining the role of early central banks in this context seems especially important. For example, Thompson (1995) and Thompson and Hickson (2001) not only emphasize the importance of the early Bank of England in financing defense, but also point to the Bank of England’s restoration of convertibility at the previous parity as a commitment mechanism that was critical to this purpose.3 In this paper, I emphasize the importance of political and legal restrictions on the Riksbank and the limiting role these restrictions had on emergency finance. The paper proceeds as follows. Section 2 provides some historical background on Sweden’s political and monetary institutions as well as its fiscal capacity. In that section, I also provide an overview of the events of this period. Section 3 examines the role that the Riksbank played in the financing of national defense during this period. Section 4 examines the effects of the Hats’ economic policies and Section 5 concludes.

2. Historical background The structure of governance in seventeenth century Sweden finds its roots in the Land Law of King Magnus Eriksson in the fourteenth century. The Land Law required that the king consult with a group of representatives to negotiate new taxes (Congleton, 2011, p. 371). The law also created a royal council chosen by the king and that would have veto power over the king’s decisions (Congleton, 2011, p. 371). From 1389 - 1521, Sweden was part of the Kalmar Union, which consisted of Denmark, Norway, and Sweden. Each country maintained its sovereignty (Congleton, 2011, p. 372). In 1523, Sweden won a war of secession from Denmark and the Kalmar Union. Military leader Gustav Vasa was elected king and the governance structure of Sweden consisted of a king, a royal council, and a parliament (Riksdag). The Riksdag consisted of four estates: the nobles, the clergy, the burghers, and the peasants. Beginning with Gustav Vasa, the crown became hereditary. Vasa also converted to Protestantism and seized the land of the Catholic Church. Governance of the state was largely controlled by the king and the king’s council, but taxes required the consent of the Riksdag (Congleton, 2011, p, 374). This structure underwent significant changes during the seventeenth century. In the early- to mid-century, the changes favored the Riksdag. Following the unpopular reign of Karl IX, the ascension of Gustav Adolphus to the crown in 1611 required an oath that the king required the consent of the Riksdag and the royal council to enact new laws and to go to war (Congleton, 2011, p. 375). The oath also required that the king consult with the royal council before creating additional taxes (Congleton, 2011, p. 375). In the mid-seventeenth century, the Riksdag acquired veto authority over new laws and began holding routine meetings rather than waiting to be called by the crown (Congleton, 2011, p. 375). The fiscal capacity of the Swedish government in the seventeenth century was limited in important respects. Heckscher (1954) refers to Sweden of the Middle Ages as a “natural economy” rather than a “money economy” because non-moneybased transactions were more common than those that used a medium of exchange. Taxes were generally paid in kind. Between the Middle Ages and the modern period, changes in military technology dramatically changed the cost of warfare and, as a result, led to the development of the modern state and its corresponding bureaucracy (Batchelder and Freudenberger, 1983). The development of fiscal capacity was especially important given that the seventeenth century was consumed by conflict, with war “raging for seventy-five of the one hundred and twenty years of the period [1600 - 1720]” (Heckscher, 1954, p. 79). In Sweden, the process of developing a modern state began under Gustav Vasa in the 1520s. Vasa hired bailiffs to collect taxes and developed tax registers (Hallenberg, 2012, p. 564). Many of these taxes were paid in kind. This bailiff system remained in place until the modernization efforts of Gustavus Adolphus in the early seventeenth century, when he switched to tax farming. The use of tax farming appears to have been an attempt to bring in monetary revenue rather than goods as Gustavus Adolphus began creating a more modern administrative state. Similarly, part of the impetus behind tariffs and the expansion of city charters under Gustavus Adolphus was that merchants were capable of paying taxes in money rather than in goods (Heckscher, 1954, p. 119). However, following Gustavus Adolphus’s death, there were protests against tax farming and Sweden reverted to the old system (Hallenberg, 2012, p. 567).

3

See also Bordo and Kydland (1995).

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The lack of fiscal capacity in Sweden during this period is most evident in the alienation of the crown’s land that began after Gustav Vasa’s death and continued through the seventeenth century (Heckscher, 1954, p. 117). The alienation of the crown’s land played such a significant role in limiting fiscal capacity, that it ultimately resulted in a reversal of this policy under Karl X Gustav and Karl XI (referred to as reduktionen, or “the reduction”). After Gustav Vasa seized the land of the clergy, there were three different types of land: (1) land owned by the crown, (2) land owned by the nobility, which was tax exempt in exchange for military service, and (3) the taxable land of “small proprietors, or ‘freeholders”’ (Heckscher, 1954, p. 30). Over the course of the century following Vasa’s death, the alienation of the crown’s land to the nobility was carried out under a number of regimes. However, the purpose differed across regimes. For example, Heckscher (1954, p. 119) argues that the alienation of crown land by Gustavas Adolphus was part of a deliberate attempt to shift the economy away from a “natural economy” and towards a monetary economy. The idea was that cities would be more likely to pay taxes in money whereas peasants working the land paid taxes in kind (Heckscher, 1954, p. 119–20). Furthermore, some of these transfers were somewhat like sales in that the crown would receive a one-time payment in exchange for the noble receiving the right to the flow of taxes in the future. In subsequent regimes, the alienation of land was not so much motivated by future goals, but rather limited fiscal capacity. War created debts that needed to be repaid. Given the limited fiscal capacity, these debts could be extinguished by a transfer of crown land. Sweden’s limited fiscal capacity also resulted in instances in which “salaries of civil servants had been withheld for long periods, accruing to a considerable sum” (Heckscher, 1954, p. 119) and the transfer of the crown’s land was used as payment. Nonetheless, there were also “instances of of sheer squandering” (Heckscher, 1954, p. 119). When Karl X Gustav ascended to the thrown in 1654, the alienation of crown land was seen as a constraint on the funding of the government and, in particular, war. While the land that had been exchanged for direct compensation had initially brought in funding the government, the right to the flow of taxation was transferred to the nobility who had been given the rights to the land. However, some of this land had been granted to the nobility without compensation, either to settle government obligations or through the squandering described by Heckscher. Overall, the effect was that the government lacked an important source of revenue. Under Karl X Gustav, reduktionen, the policy of reverting noble land back to the crown, was carried out to a moderate degree. The idea behind the policy was to revert land to the crown for which there had been no compensation. In doing so, the crown would acquire the rights to the taxes from this land and therefore a source of revenue. A more significant change occurred following the death of Karl X Gustav, both with regards to the political power of the crown and fiscal capacity. When Karl X Gustav died in 1660, his son Karl XI was not yet old enough to ascend to the thrown and would not take the thrown until 1672. A regency council was appointed to rule in the intervening period. Given the persistent state of war during this time period and the long time in which the regency council would have to govern, Swedish policy was one aimed at maintaining peace and the status of the Swedish army (Roberts, 1965, p. 161). However, maintaining a peaceful army created a challenge that was different from an army at war. The Swedish army largely supported itself during times of war, with troops being fed and otherwise compensated through its occupation of foreign territory. However, Sweden lacked the fiscal capacity to maintain troops at home while at peace (Roberts, 1965, p. 161). The regency council did not seek any continuation of reduktionen and this was probably for self-serving reasons. Instead, the regency council attempted to secure peace by signing an agreement with France that provided subsidies to the Swedish government in exchange for a military alliance. Karl XI ascended to the thrown in 1672. Yet just two years later, in 1674, Sweden found itself at war because of this agreement. The condition of the military and the “administrative and financial weakness” that were made apparent by the war “convinced [Karl XI] of the incompetence and self-seeking of the Regents” (Roberts, 1965, p. 164). The war convinced the king that Sweden needed to maintain peace, but that this required strength and therefore a large standing army (Roberts, 1965, p. 165). To finance this plan, he extended the policy of reduktion. His policy of reverting noble lands back to the crown was quite significant. According to Heckscher (1954, p. 127), the landholdings of the nobility declined by more than half from 1652 to 1700, with much of this change occurring under Karl XI. This was an approximately complete reversion of the land that had been assigned to the nobility since the death of Gustav Vasa. In terms of fiscal capacity, reduktionen had two significant effects. On the one hand, the policy allowed the government to finance a standing army. Of the land that was reverted back to the crown, some was assigned to the soldiers so that they could farm off of the land. Thus, the reversion of the land to the crown not only resulted in a new (or perhaps renewed) source of revenue, but also allowed for in-kind compensation to soldiers. On the other hand, the reversion of land to the crown reduced the use of money in public finance. As Heckscher (1954, p. 124) notes, “once more the revenue of the crown consisted of grain, meat, iron, and scores of other commodities.” In addition to the re-emergence of the so-called “natural economy”, reduktionen wiped out a significant amount of wealth from the nobility. This is especially important because government borrowing at this period of time was largely confined to wealthy financiers (Heckscher, 1954, p. 106). The combination of these effects was to weaken the long-run fiscal capacity of the state. Reduktionen was also the beginning of additional changes in Sweden’s political governance. The war combined with Sweden’s limited fiscal capacity undermined Karl XI’s trust in both the regency council and the king’s council. The king’s council had provided “unsolicited advice against proceeding with the reduktion” (Roberts, 1965, p. 175). The king took the opportunity to ask the Riksdag if the advice of the council was binding in any way. The Riksdag responded that the king was only required to consult the council, but was not bound by its recommendations (Roberts, 1965, p, 175). This outcome was no doubt the result of the dissatisfaction of the non-noble estates with the decision-making of the council and the

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weakened power of the nobility. Subsequently, the Riksdag gave up its oversight of tax policy (Roberts, 1965, p. 177). Karl XI was granted an absolute monarchy, one that would continue under his son, Karl XII. The early Swedish monetary system was quite complex. As of 1620, Sweden had a silver standard (Edvinsson and Ögren, 2014). However, in the early 1620, Spain started minting copper coins using Swedish copper. The increase in the demand for copper caused copper prices to rise. Expectations of future price increases contributed to Sweden’s adoption of a copper standard in 1624 (Edvinsson, 2012). Nonetheless, silver continued to circulate alongside copper. According to Edvinsson (2012) and Edvinsson and Ögren (2014), there were seven different forms of payment that circulated in the period that followed with flexible exchange rates between some forms of payment. The gold ducat and the silver riksdaler were used in international transactions while copper coins and silver coins circulated domestically. However, there were problems pertaining to copper. Since copper money was stamped in terms of its official value in silver and the price of copper was substantially below the price of silver, one needed a great deal more copper to equal one daler (the Swedish unit of account at the time) than one would need of silver. As a result, copper plates had to circulate alongside silver coins. Heckscher (1954, p. 89) points out that a 10 daler plate weighed 43 pounds. Copper had to be carried around in wagons or on sleds.4 Nonetheless, since the market price of copper was below the metallic content of the copper plates, it was the copper plates that served as a medium of exchange even though the silver daler, or daler silvermynt, was the unit of account (Heckscher, 1954, p. 90–91). In 1656, while Sweden was at war with Poland, King Karl X Gustav chartered a bank, Stockholm’s Banco. The bank had two divisions that were meant to be kept separate. The first division was the exchange bank, which would accept deposits and allow withdrawals on demand. The exchange bank would charge a fee to hold the deposits. The second division was a loan bank, which served as an intermediary between savers and borrowers. The bank also introduced the first modern bank notes in Europe, which were referred to at the time as “credit notes.” The bank notes were a successful innovation because they allowed depositors to leave their heavy copper plates at the bank and use bank notes instead. The convenience created by the notes were evident by the fact that they actually exchanged “at a premium over the awkward copper money” (Heckscher, 1954, p. 92). Despite the benefits of note issuance, Stockholm’s Banco didn’t last long. While the loan bank initially required collateral for loans, it eventually started lending on personal guarantees (Wetterberg, 2009, p. 37). Ultimately, the bank over-issued bank notes. Since the notes were redeemable for copper or silver, their issuance was subject to the Law of Reflux (Glasner, 1989).5 The wave of redemptions in the aftermath of the over-issuance was more than the bank could handle and the bank had to be liquidated. Whereas Stockholm’s Banco had been under the control of the Crown, the Riksdag used the opportunity of the bank’s liquidation and the fact that Karl XI was not yet old enough to ascend to thrown to set up a new bank owned and overseen by the Riksdag (Fregert, 2018, p. 91). The new bank was established in 1668 and was called the Riksens Ständers Bank, or Bank of the Estates of the Realm. Today, the bank is known as the Sveriges Riksbank. The structure of the bank was similar to Stockholm’s Banco in that it had an exchange bank and a loan bank. The Riksbank was run by a board known as the General Council that was “appointed by the parliament among its own members” (Fregert, 2018, p. 91). In contrast to Stockholm’s Banco, the Riksbank was prohibited from issuing bank notes. The bank was also prohibited from lending to the government (Fregert, 2018, p. 97). Nonetheless, this latter restriction was never adhered to during times of war as the Riksbank lent to Karl XI during the Scanian War (1676–1679) as well as each of the subsequent wars discussed in this paper. The first major test of the bank came at the turn of the 18th century. When Karl XII came of age, he was faced with military action from Russia, Denmark, and Saxony, all of whom were attempting to seize the opportunity to take advantage of the young king of Sweden. The Great Northern War began in 1700. Contrary to expectations, Karl XII defeated Denmark and Saxony relatively quickly. By 1707, the Russians were willing to negotiate peace, but Karl XII was intent on punishing his enemies for what he deemed to be an unjust war and invaded Russia. The Riksbank was an important source of funding for the war, providing loans to the Crown. However, the restriction that prevented the bank from issuing bank notes limited the Riksbank’s ability to provide financing. The initial success of the war created confidence in the stability of the bank and helped to attract deposits (Wetterberg, 2009, p. 65). Since there was a restriction on bank note issuance, the only way to ensure adequate funding was if deposit growth exceeded the growth in loan requests from the Crown. As shown in Fig. 2, as the war continued, advances to Karl XII for the war began to take up a larger and larger fraction of the bank’s balance sheet. The fraction of the total balance sheet that was devoted to government loans at the turn on the century was a little less than two percent. By 1719, government loans accounted for nearly 60% of the balance sheet. The loan requests grew much faster than deposits. The critical juncture in the war came long before this ratio reached its peak. By May of 1709, the bank had only financed one-third of the king’s most recent request for funds and “the paymaster general sent a desperate appeal to the board of directors: there was no money left, troops in the field and garrisons in fortified towns were dying of starvation” (Wetterberg, 2009, p. 66). The appeal, however, was for naught because the bank did not have the funds. The

4 Heckscher (1954, p. 90) even noted that “some burglars who had broken into a cellar and found there a small sum of money had to leave it behind because they could not lift it.” 5 The term “Law of Reflux” is subject to some controversy in the literature. Without inheriting or endorsing any of the baggage associated with the previous use of the term, I would like to note that I am using it in the form used by Glasner (1992, p. 868) as referring to the assertion that “banks cannot overissue money, because any issue would return to them in debt repayments or as a demand for redemption.” The basic idea I am trying to communicate with this term is that the demand for bank notes is finite. In the event of overissue, the excess supply of notes will be redeemed for the underlying asset.

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Fig. 2. Loans to the Government as a Fraction of the Size of the Balance Sheet. Source: Fregert (2014) and author’s calculation.

problem manifested itself at the Battle of Poltava when Karl XII led his outnumbered troops who were short on supplies into battle with the Russians. Sweden lost decisively and never recovered from the defeat. Karl XII died in battle in 1718. Sweden continued fighting the war until 1720 when they finally negotiated peace. In defeat, Sweden lost much of Swedish Pomerania and the Baltic states of Estonia and Livonia. Karl XII left no heirs. As a result, there was uncertainty about who would ascend to power. Ulrika, his sister, succeeded her brother in exchange for concessions. She agreed to a new constitution that concentrated power in the Riksdag in exchange for her ascension to the thrown as Queen. She later abdicated in favor of her husband, who accepted more concessions (Wetterberg, 2009). The approximately 50 year period that followed has come to be known as Frihetstiden, or the “Age of Freedom” (or “Age of Liberty”). This time period in Sweden is one of the earliest modern experiments with constitutional monarchy. The first 20 years of the period were years of peace and recovery from war (Heckscher, 1954, p. 130–2). However, by 1741, Fredrik Gyllenborg was appointed the chairman of the board of directors at the Riksbank and this radically changed policy at the bank. Fredrik Gyllenborg was a member of a political party known as the Hats. Fredrik’s brother, Carl, was the prime minister. This paved the way for the Riksbank to have a role in both foreign and domestic policy. Furthermore, the “Riksbank’s status thereby shifted from being independent of the executive to an authority controlled by the executive. The Riksbank became a tool for carrying out the government’s goals for foreign and fiscal policy” (Fregert, 2018, p. 100). The interaction between monetary and fiscal policy is important during this period. The new constitution that was signed after Karl XII’s death gave all of the power to the Riksdag with an elected executive (Fregert, 2010, p. 4). Within the Riksdag, taxation was determined by a taxation committee that consisted of all four estates. Ordinary taxes that existed prior to this period continued and were not subject to debate within the Riksdag (Fregert, 2010, p. 8). Temporary taxes, however, required a vote. Indirect taxes could be imposed by a majority vote whereas direct taxes required consent of each estate (Fregert, 2010, p. 8). However, the government’s expenditures, monetary policy and foreign policy “were considered secret state matters” and “decided by the Secret Committee by a simple majority vote” (Fregert, 2010, p. 4). This committee consisted of 100 members of the Riksdag. Half of the members were from the nobility and the other half was split between the clergy and the burghers. The peasants, although represented in the Riksdag, had no representation in the Secret Committee. The state budget was proposed by the budget committee in the Riksdag and the government’s budget office (Fregert, 2010, p. 6). The budget was then decided by a majority vote in the Secret Committee (Fregert, 2010, p. 7). The budget was then carried out by a budget commission that followed instructions from the Secret Committee (Fregert, 2010, p. 7). The Riksbank continued to be governed by a General Council that was chosen by the Secret Committee. The bank’s behavior was monitored by a subcommittee of the Secret Committee known as the Banking Committee (Fregert, 2010, p. 8). Future tax revenue was pledged as collateral for government borrowing at the Riksbank (Fregert, 2010, p. 8). The overall institutional setup ultimately created what was effectively a consolidated monetary and fiscal policy controlled by the Secret Committee. The constitution required that “the budget should balance, with an escape clause, that is discretion, in exceptional circumstances” (Fregert, 2010, p. 5). In practice, however, the fact that taxation was determined by all four estates whereas the Secret Committee controlled both the budget and the central bank ultimately led to persistent deviations from a balanced budget. In fact, Fregert and Gustafsson (2008) show that actual borrowing from the Riksbank corresponds closely with budgeted borrowing after 1741. This suggests that borrowing might not have always been used for exceptional circumstances. Given the consolidated nature of monetary and fiscal policy, it is important to consider the role of political parties during this time. During Frihetstiden, there were two major political parties in the Riksdag, the aforementioned Hats, and the Caps.

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The Hats controlled the Riksdag from 1739 to 1765. Their motto, “Svensker man i svensk dräkt” (“Swedish men in Swedish clothes”), was typical of their mercantilist philosophy (Eagly, 1969, p. 748). The Hats sought to boost domestic industry through “export subsidies, direct financial support, low interest loans, and high protective tariffs” (Eagly, 1969, p. 748). The Hats saw the Riksbank as an important source of financing for industry. Conveniently enough, and contrary to early Riksbank history, bank notes became publicly receivable in 1726. Something called transportation notes had appeared in 1701, but at the time were more comparable to traveler’s checks than bank notes and only 16 such notes appeared on the Riksbank balance sheet by 1710 (Edvinsson and Ögren, 2014, p. 301). In 1726, these notes were made publicly receivable. After this change, individuals began removing the signature portion from the transportation notes that denoted the transfer and the notes began to circulate as typical bank notes and eventually became the favored medium of exchange (Edvinsson and Ögren, 2014, p. 302). The re-introduction of bank notes was important because the Hats apparently believed that the money supply had a permanent effect on output. I say “apparently” because this is the common interpretation of Hat ideology outlined by Eagly (1969), for example. However, Edvard Runeberg, a Hat economist whose work Eagly describes, seems to argue that output is inversely related with speculative money balances. Since speculative money balances tend to be drawn from what would otherwise be transactions balances, this would seem to suggest that Runeberg was concerned with hoarding, which might manifest itself in what we might now call excess money demand or a money shortage. In addition, Wetterberg (2009, p. 97) cites support for the Hats position from a Swedish political journal that states, “As to the sufficient Money stock, a Nation ought never to lack money in proportion to its people and land. It is and always will be a fault in the Finance department as soon as a Nation suffers a shortage.” Thus, there seems to be some indication that the Hats were primarily concerned with an excess demand for money or a money shortage, which is not the same thing as believing that the money supply has a permanent effect on output. Wennerlind (2014) argues that this misconception is generally true of critiques of mercantilists. What the Hats really believed is beyond the scope of this paper, but the fact remains that they did use note issuance to finance these private loans whether they were concerned with money shortages or genuinely believed in a permanent, positive relationship between output and the money supply. Differences between the Hats and the Caps are also evident in foreign policy.6 During the early years of Frihetstiden, Arvind Horn, a member of the Caps, guided policy as prime minister. He had avoided any further military conflicts in the aftermath of the Swedes’ defeat in the Great Northern War. However, the Hats’ rise to power altered foreign policy. In 1741, the Hats saw the death of Empresss Anna Ivanovna of Russia as an opportunity to attack Russia and reclaim the land lost in the Great Northern War. The Hats thought that they could capitalize on any confusion or conflict in Russia over claims to power. However, “Elisabeth Petrovna seized power as Empress of Russia and duped the Swedes, who lost the whole of Finland” (Wetterberg, 2009, p. 86). The war was not only a disastrous failure, but it was also largely financed through the printing of bank notes. This is despite the fact that taxes had been increased and expenditures reduced in the budgets produced by the Secret Committee (Fregert, 2010, p. 16). The Secret Committee also sought foreign loans, but was unable to secure them and therefore had to rely on the Riksbank (Fregert, 2010, p. 170). The expansion of note issuance caused by a combination of loans to the government and the Hats’ loans to manufacturers caused a loss of reserves and by 1745, the ability to redeem bank notes for copper plates was indefinitely abolished (Heckscher, 1954, p. 197; Wetterberg, 2009, p. 88). In 1757, Sweden declared war on Prussia, which was already involved in the Seven Years War with Russia and France.7 The Pomeranian War, as it is called in Sweden, was fought over land along the Baltic Sea in what is now Germany and Poland that was once part of the Swedish Empire and had been lost to Prussia in the Great Northern War. The Hats once again saw an opportunity to reclaim the land lost in the Great Northern War, but this time had some financial support from France. The Swedes were ultimately unsuccessful in recovering the land because they had to negotiate peace after an alliance formed between Russia and Prussia when Russia switched sides in the broader conflict in 1762. Outside of the funding Sweden received from France, the war was financed by loans from the Riksbank and the corresponding note issuance (Edvinsson and Ögren, 2014, p. 304). The Hats remained in power until 1765 when high inflation finally led to their electoral defeat. The Caps had been critical of the mercantilist policies of the Hats, arguing that they benefited favored interests and that the corresponding note issuance was causing inflation (Eagly, 1969, p. 751–2). Upon taking office as the majority party, the Caps implemented a deflationary policy designed to return the price level and exchange rate to the levels that existed before the suspension of convertibility. What followed was a 5% decline in real GDP per capita over the next 3 years. The Caps’ time as the majority party was therefore short-lived, with the Hats returning to power in 1769. However, even this transition was short-lived. A coup d’état returned the monarchy to power in 1772.

6 In fact, Wetterberg (2009, p. 93) says that the term “Caps” was actually short for “Nightcaps.” Apparently, this was meant as an insult meant to imply that the Caps were soft on foreign policy. The term Hats, on the other hand, derived from the tricorne hats worn by the aristocracy and military leaders. 7 Wetterberg (2009, p. 92) notes an interesting connection. Following the defeat in the Hats’ Russian War, the Empress of Russia imposed the condition that the Swedes make Adolf Fredrik of Holstein the heir to the Swedish thrown. He became king in 1751. In 1756, his wife, Queen Lovisa Ulrika, attempted to instigate a coup d’état. Following the failed coup, the Hats who controlled the Riksdag reprimanded the queen.

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3. The Riksbank and national defense 3.1. A conceptual framework A discussion of early central banking must recognize that a primary role of these banks was to provide a source of financing for national defense. For example, the Bank of England was chartered by Parliament in 1694 in exchange for stockholders agreeing to purchase £1.2 million of government debt at 8 percent interest, a rate far below the “market” rate for the king’s debt (Glasner, 1989, p. 34). Despite initially being forbidden from lending to the executive, the Riksbank similarly played an important role in financing the Great Northern War, the Hats’ Russian War, and the Pomeranian War. Central banks represented a potentially valuable financial innovation from the perspective of governments faced with the possibility of large-scale, open-ended, and potentially recurring military conflicts. In these types of military conflicts, the ability to raise sufficient tax revenue in such a short period of time is very limited and costly. Governments would instead prefer to engage in tax smoothing (Barro, 1979a). In theory, the increased lending capacity from the creation of a central bank enhances a government’s ability to smooth taxes over time. Furthermore, in practice, it appears that the British engaged in tax smoothing for the century after the Bank of England was chartered (Sargent and Velde, 1995). However, the importance and the magnitude of the size of the financial innovation depends on the constraints of the bank. The constraints associated with early central banks were typically legal and/or political. Put differently, it seems obvious that the ability to borrow from a bank during times of war is clearly a benefit to the government. The extent of this benefit is limited by the constraints placed on borrowing from the bank. I define three types of constraints on borrowing for open-ended military conflicts. The main idea is that for central banks to be a useful and important source of emergency finance, the bank must be able to expand the value of its balance sheet in real terms during the emergency. In other words, the central bank needs to provide the government with a net increase in purchasing power. The ability of the bank to expand its balance sheet in real terms and the constraints on government borrowing depend on the monetary regime. I now consider 3 possible regimes that are relevant to the Swedish experience and the corresponding government borrowing constraints. First, under a commodity standard with a complete restriction on the ability to issue bank notes, the price level is anchored by the convertibility since “the determination of the absolute price level amounts to the determination of the relative price of the reserve commodity” (Barro, 1979b, p. 13).8 The ability to expand the balance sheet in nominal terms is therefore generally equivalent to a real expansion. Since the commodity itself is needed to make purchases, the ability to expand the balance sheet is constrained by the initial commodity reserves of the bank and the ability to grow deposits at least as fast as the demand for loans. If deposits grow at a slower rate than the demand for loans, then reserves will decline until the bank is no longer able to provide a sufficient quantity of the commodity to cover the expenditures. Second, under a commodity standard with the ability to issue bank notes, the previous constraint is relaxed. Since the bank can issue bank notes, the quantity of the physical commodity is no longer a constraint. However, if the central bank maintains convertibility into the commodity, the relevant constraint is the Law of Reflux (Glasner, 1989, p. 59–66). In other words, with a convertible paper money, an excess supply of paper money will result in individuals redeeming the paper for the commodity at the bank. Thus, the ability of the central bank to expand note issuance is constrained by the public’s willingness to hold the newly created notes. In this regime, the constraint is best represented by the reserve ratio, or the ratio of reserves to bank liabilities. A decline in the reserve ratio might indicate an increase in the demand for bank notes. However, a sufficiently low reserve ratio might call into question the bank’s ability to maintain convertibility and therefore cause a run on the bank as note holders all try to convert their notes into the commodity. Third, under an inconvertible paper money regime, the Law of Reflux no longer applies and therefore the previous constraint is relaxed. Nonetheless, the constraint on financing through the issuance of inconvertible bank notes is inflation. Under an inconvertible regime, the price level is no longer pinned down by the supply and demand for some underlying commodity, but rather is now determined by the supply and demand for bank notes. If the central bank can anchor longterm inflation expectations, then the expansion of issuance of bank notes can lead to an increase in the real size of the central bank’s balance sheet since the money supply will rise faster than the price level. If the central bank fails to anchor long-term inflation expectations, then the real size of the central bank’s balance sheet will decline as the increase in the money supply coincides with a simultaneous reduction in money demand, and the price level rises faster than the supply of bank notes, as shown in Fig. 3. To illustrate the significant differences in the constraints on government borrowing, it is perhaps useful to consider a comparison. The structure of early central banks was distinct. Lending at the Bank of England was largely done through the discounting of bills of exchange. The liabilities of the Bank of England were predominantly bank notes. These notes were redeemable for gold and circulated alongside gold and silver coins (Viner, 1937). Deposits were a small fraction of the money supply (Hendrickson, 2018). Loans and advances to the government could be financed by the issuance of bank notes. In contrast, the Riksbank initially prohibited the issuance of bank notes for any purpose given the experience with and the failure of Stockholm’s Banco. As a result, the liabilities of the Riksbank were entirely made up of deposits. The bank

8

See also Thompson (1974), Niehans (1979), Glasner (1989), and Sumner (2015).

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Fig. 3. The supply and demand for money. This graph shows the nominal money supply on the horizontal axis and the price of money, 1/P, where P is the price level, on the vertical axis. The supply curve is vertical because the quantity supplied is determined by the central bank. An increase in money growth is associated with a rightward shift in the money supply and a leftward shift in the demand for money. The real value of money balances therefore decline.

was initially set up with two distinct divisions, an exchange bank and a loan bank. The exchange bank stored non-interestbearing deposits. The loan bank issued interest-bearing deposits to finance loans. While deposits in the exchange bank could be withdrawn on demand, deposits at the loan bank were effectively loans to the bank; depositors had to wait six months before they had the ability to withdraw.9 The inability to issue bank notes at the Riksbank was a constraint on borrowing for armed conflicts. In order for the crown to borrow, the Riksbank would have to attract a sufficient amount of new deposits. In contrast, the constraint faced by the British was not a constraint on deposits, but rather the reserve ratio at the Bank of England. If the Bank of England expanded its note issuance beyond the demand for bank notes, these bank notes would return to the bank for redemption through the Law of Reflux. An expansion of bank notes, if not returned via the Law of Reflux, would reduce the reserve ratio (the ratio of reserves to total liabilities). The reserve ratio was the relevant constraint in the following sense. As lending to the government increased, the supply of bank notes would rise relative to reserves. Under a commodity standard, a sufficiently low reserve ratio could lead to a loss of confidence in the bank to honor redemptions. Larger government debt combined with military defeats might create a fear of default, which could lead to a run on the bank. The ability of the bank to withstand such a run would depend on its reserve ratio. The British seemed to recognize this constraint early on since they suspended the convertibility of bank notes into gold as early as 1695, just one year after the bank was established, to finance war with France.10 Nonetheless, while the suspension of convertibility relaxes the constraint associated with the reserve ratio, it creates a new constraint: inflation. Glasner (1989), Thompson (1995), Bordo and Kydland (1995), and Thompson and Hickson (2001) argue that the need for war finance provides an incentive for governments with central banks to commit to price stability during peace. The argument is as follows. A commitment to a commodity standard anchors price level stability. In an emergency, such as a war, the suspension of convertibility relaxes the constraint on the reserve ratio by effectively transferring the risk of default to a risk of inflation. A credible commitment to restore convertibility at the previous parity can help to anchor price level expectations. Given such a commitment, the price level should rise less than the increase in the supply of bank notes, thereby implying that the creation of bank notes yields a real expansion of the central bank’s balance sheet and therefore greater real purchasing power for the government to use for military expenditures. The lack of a commitment to impose deflation after the resumption of convertibility at the previous parity would lead to expectations of higher inflation over the long term. This point is important. For the government to be able to finance potentially long-term, open-ended, large-scale military expenditures, they would need the size of the central bank’s balance sheet to expand in real (not just nominal) terms. The failure to promise to restore convertibility at the previous parity would fail to anchor inflation expectations. As a result, the expansion of the balance sheet would result in higher expected inflation and therefore cause individuals in this period to want to substitute away from notes into real assets. This would reduce the demand for real money balances and undermine attempts to finance expenditures through the issuance of bank notes. This theory is

9

While these were meant to be separate divisions, the lines were blurred (Wetterberg, 2009). It is important to note here that I am not claiming that the reserve ratio was an explicit policy tool of the Bank of England, but rather is useful for discussing the constraints facing the bank in theory. Thompson and Hickson (2001) argue that the necessity of this suspension was likely known by William III since he was Dutch and Holland had experienced a military defeat in 1676 when its own central bank restricted note issuance to equal the supply of reserves. 10

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given empirical support by Anitpa (2016). She shows using weekly and bi-weekly data that military and political news can explain structural breaks in the difference between the market price of gold and its mint price (the agio) in Britain during the Bank Restriction Period from 1797 - 1821. Given the close correlation between the agio and the price level, this provides support for the view that the suspension of convertibility transfers the risk of default to a risk of inflation in the event that the government cannot maintain its commitment to restore convertibility at the previous parity. Overall, what this conceptual framework and comparison between the Bank of England and the Riksbank illustrates is that there are three constraints on emergency military expenditures: 1. A deposit constraint. The inability to issue bank notes implies that the government faces a limit on its borrowing at the central bank. Since the government cannot borrow more than the total amount of deposits at the central bank, its lending is constrained by deposit growth. 2. A reserve ratio constraint. Allowing bank note issuance relaxes the deposit constraint, but creates a new constraint. A government’s ability to borrow is limited by the central bank’s ability to maintain convertibility. 3. An inflation constraint. Suspending (or eliminating) convertibility at the central bank relaxes the reserve ratio constraint, but creates the constraint of inflation. Promises to restore convertibility can be seen as an attempt to anchor price level expectations to facilitate a real expansion of the balance sheet. These constraints are important to understand the likelihood of military success. In large-scale, open-ended conflicts of the type witnessed during the seventeenth and eighteenth centuries, military success was contingent on the ability to finance such conflicts. I examine these various constraints for the eighteenth century Riksbank to determine the role that these constraints had on Swedish military outcomes. As I have explained, over the course of the eighteenth century, the relevant constraint on defense varied. During the time of Karl XII, given the restriction on the issuance of bank notes, the relevant constraint was a constraint on deposits. As such, one would anticipate that Swedish military success during the Great Northern War would depend on the growth of deposits at the Riksbank. In particular, a measure of the degree to which this became a binding constraint, one should look at government loans as a fraction of deposits. As government loans increase relative to deposits, the government’s financial constraint will begin to bind. In the absence of contingencies, one would therefore expect to see the military begin to suffer defeats. Furthermore, one would expect the government to seek alternative forms of finance once they came close to the constraint. I therefore have two predictions that correspond to this period: •

•

Prediction 1: If the borrowing constraint was binding, Swedish military success under Karl XII should be negatively related to the ratio of government loans to deposits at the Riksbank. Prediction 2: If the borrowing constraint was binding, one would expect the government to resort to alternative means of finance only after the loan-to-deposit ratio reaches a point at which central bank financing is no longer feasible.

The Great Northern War marked a significant turning point. With the loss, Sweden lost a significant amount of its empire. In fact, Sweden never recovered the lost territory and never again rose to imperial status. Thus, if the constraints on the Riksbank were binding and at least partially to blame for the military defeat, then these constraints are to some degree at fault for the decline in the Swedish Empire. Nonetheless, the inability to restore the Swedish Empire was not due to the lack of effort. Sweden twice went to war during Frihetstiden, first during the Hats’ Russian War and later during the Pomeranian War. During Frihetstiden, the constraints on financing through the Riksbank changed significantly. Initially, the main difference was the ability of the Riksbank to issue bank notes. During the Hats’ Russian War, the ability to issue bank notes meant that the constraint on government borrowing was maintenance of convertibility at the Riksbank. A useful proxy for this constraint is the reserve ratio. In order to examine the ability of Sweden to wage the type of large-scale and open-ended military conflict necessary to reclaim the land lost to the Russians, it is important to consider whether Sweden maintained the financial capacity to engage in this type of conflict. I formulate the following prediction with regards to the government borrowing constraint: •

Prediction 3: If the borrowing constraint was binding, then one would expect that (a) the Hats’ Russian War led to a dramatic decline in the reserve ratio, and (b) the decline in the reserve ratio would force the Hats to look for other methods of financing.

In 1745 convertibility was suspended at the Riksbank. Both Heckscher (1954, p. 197) and Wetterberg (2009, p. 88) imply that there was no promise of a resumption of convertibility.11 The framework I introduced suggests that the relevant constraint shifted from the reserve ratio to inflation. This is particularly relevant to Sweden’s entry into the Pomeranian War in 1757. In order to use the central bank to finance the sort of large-scale, open-ended conflict that would have been necessary to win the Pomeranian War, the bank would have had to maintain its ability to increase the real size of its balance sheet. By financing a large fraction of the loans for the war by issuing bank notes, the real size of the bank’s balance sheet could only increase if inflation expectations remained anchored. Higher expected inflation would lead to greater opportunity cost of holding money and a corresponding reduction in the demand for real money balances. I make the following prediction: 11 Heckscher refers to the suspension of convertibility as a “permanently irredeemable paper money.” Wetterberg writes that convertibility had been “abolished.”

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Fig. 4. Metallic bank reserves at the Riksbank (in daler silvermynt). Source: Fregert (2014).

•

Prediction 4: If the inflation constraint is binding, then one would expect to see a precipitous decline in the growth rate of the real value of bank note balances and possibly an absolute decline in the real value of bank note balances. Further evidence that this was a binding constraint would be to find out that the decline in real balances coincided with attempts for alternative means of financing. In the following subsection I examine each of these hypotheses.

3.2. Empirical analysis Econometric analysis of constraints on emergency government is difficult given that the only data available for the time period are annual. In addition, while the Great Northern War lasted for two decades, the Hats’ Russian War and the Pomeranian War were considerably shorter. As a result, I will use a mixture of empirical analysis to identify correlations in the data for the Great Northern War as well as provide evidence that Sweden quickly reached financing constraints during the latter two wars. When Karl XII became king in 1697, Sweden controlled much of the land that bordered the Baltic Sea. Karl XII, however, was still short of his 15th birthday. Hostilities between Denmark and Sweden remained from the Scanian War during Karl XI’s reign. In 1698, Denmark tried to arrange for a marriage between Karl XII and the Danish princess (Bain, 1895, p. 50). However, Karl XII’s sister had married Frederick IV, Duke of Holstein, and Karl XII struck up a friendship with the Duke. Holstein, which is a part of modern day Germany to the south of Denmark (although not bordering Denmark), had been in constant conflict with Denmark. The continuing conflict between Denmark and Holstein meant that Karl XII’s friendship with the Duke made it impossible for any alliance with Denmark. As a result, Denmark had to look for other allies (Bain, 1895, p. 51). Denmark formed an alliance with Saxony and Russia. The alliance, motivated by a desire to re-claim lands that they had previously lost to Sweden, began an offensive against Sweden in 1700. The Great Northern War lasted until 1721 when Sweden was forced to accept defeat. As alluded to in the previous section, what was particularly important about the war for the purposes of this paper was that Karl XII viewed the Riksbank as an important source of financing. However, the limitation on note issuance at the Riksbank meant that the extent to which the Riksbank could be a source of financing for the war depended upon the reserves of the bank and the ability of the bank to attract new deposits. The bank, however, was unable to do so. As shown in Figs. 2 and 4, respectively, loans as a percentage of the bank’s balance sheet rose rapidly and reserves at the Riksbank started to decline in 1705. While reserves increased during the early success of the war, by the end of the year 1708, reserves had declined to 827,737 daler silvermynt, which was approximately half of the amount of reserves the bank had just 3 years earlier. The rapid decline in reserves foreshadowed future problems with financing the war through the bank. As early as August 1708, despite much military success, the military showed signs of resource constraints as “bread was running short and there was scarcely any fodder for the horses” (Bain, 1895, p. 164). By January of 1709, conditions had gotten worse for the Swedish army. As Bain (1895, p. 181) details, “Supplies were running so short that it was as much as the men could do to keep body and soul together. Saltpetre had now to be used instead of salt, and there was not sufficient wine left to give the sacrament to dying soldiers.” Karl XII requested a loan for 60 0,0 0 0 daler kopparmynt (20 0,0 0 0 daler silvermynt), but by May the Riksbank had only given the king about one-third of that amount (Wetterberg, 2009, p. 66). As the data in Fig. 4 show, this is because the bank simply did not have the money to lend. By the end of 1709 reserves had fallen to 205,454 daler silvermynt.

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Table 1 Negative binomial regression results. Variable

Coefficient

Constant

1.05 (0.33) −2.93 (1.02) 20 0.15

Gov’t loan/deposits N Pseudo R2

The point at which both supplies reached critical shortages and the Riksbank was unable to fund additional loans to the Crown immediately preceded the Battle of Poltava that began in June 1709. Bain (1895, p. 182) explains that Karl XII’s army was much too weak. It was not so much that his army had notably diminished (his Polish exploits had been performed with half as many men) as that he had next to no artillery left, and his powder was not only running short, but had so deteriorated with repeated wetting as to be almost useless. It is said that when a shot was fired off it sounded no louder than the clapping together of a pair of gloves, while the bullets fell down in the sand scarcely thirty paces from the mouth of the gun that fired them. There was such a dearth of bullets too, that the Swedes were glad to collect, and make use of, the spent balls of the enemy. Wetterberg (2009, p. 66) similarly notes that in May 1709, “the paymaster general sent a desperate appeal to the board of directors: there was no money left, troops in the field and garrisons in the fortified towns were dying of starvation. The reply was that money was not coming in.” The battle lasted a little over a week and the Swedish army was decimated in the battle. During the final stages of the battle, Bain (1895, p. 188) describes the Swedish army as being outnumbered 10-to-1 and “exhausted by hunger and fatigue, with bad powder, no artillery, nay, not even cavalry to support them.” Karl XII, who was injured in battle sought refuge in the Ottoman Empire before ultimately returning to battle later in the war. The war continued on without him and unsuccessfully so. In fact, Sweden never recovered from this devastating defeat. Thus, to summarize, the turning point in the war came shortly after Sweden reached its borrowing constraint through the Riksbank. While it is true that the Swedes had also been outnumbered, this was typical of previous battles when Karl XII and the Swedish army had been victorious. As further evidence that the government’s borrowing constraint became binding is that the news of a major defeat at the Battle of Poltava led to a run on the bank in August of 1709 (Wetterberg, 2009, p. 66). The run was evidently concentrated in the loan bank. Since deposits at the loan bank had to be left at the bank for a certain period of time, it had become common practice for individuals to use deposit certificates as a sort of medium of exchange (although this was not generally approved by the bank) or to borrow from the bank using one’s deposit as collateral (which gave access to liquidity in the meantime). The board of directors at the bank announced that they were closed to withdrawals at the loan bank in September of 1709 (Wetterberg, 2009, p. 66; Fregert and Jonung, 1996, p. 450; Fregert, 2018, p. 99). Deposit certificates still circulated, but did so at a discount (Fregert, 2018, p. 99). Withdrawals were limited between 1709 and 1718 (Fregert, 2018, p. 99). Further evidence that the government faced a binding borrowing constraint was that Karl XII had to resort to desperate financing measures (Wetterberg, 2009, p. 68–70). In 1711, the king proposed issuing bank notes, but was rebuffed by the bank. Afterwards, the king argued that he had meant that the Exchequer would issue the notes (Wetterberg, 2009, p. 68–69). In 1713, the king had to resort to taxation and instituted a 2% tax on wealth and a 1% tax on deposits at the Riksbank (Wetterberg, 2009, p. 69). In 1715, the king started minting token copper coins, the metallic content of which was only a fraction of the face value and he issued currency notes and promissory notes to soldiers (Wetterberg, 2009, p. 70–72). The value of these issuances depreciated significantly and therefore none of these experiments turned out to be an adequate source of financing. Taken together, this evidence suggests that the borrowing constraint led to a shortage of resources for the Swedish army and that this shortage coincided with the turning point in the war. To examine the extent to which the constraints on the bank adversely affected the performance of the Swedish army, I estimate a negative binomial regression model to determine the effect of the financing constraint on the outcome of battle. Since data on the Riksbank balance sheet is annual, there is a limited set of observations. Nonetheless, this sort of exercise might be able to outline correlations in the data. The dependent variable in the regression is the number of battles won by the Swedish army in a given year. As an independent variable, I use the ratio of government loans to total deposits at the Riksbank at the end of the previous year. The results are shown in Table 1. Standard errors are in parentheses. As shown in Table 1, a higher ratio of government loans to deposits at the end of the year is negatively related to the number of battles won in the subsequent year. This coefficient is negative and statistically significant at the 1% level. It is possible for critics to cast doubt on this result as merely due to the fact that Sweden was accumulating a lot of debt at the same time that they were losing the war. However, there are reasons to doubt such a criticism. First, the qualitative evidence presented above suggests that the timing of the binding of the borrowing constraint coincides with supply shortages and significant defeats. Second, the desperation regarding funding led to the government paying for its expenditures using

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Fig. 5. The ratio of reserves to total liabilities. Source: Fregert (2014) and author’s calculation.

methods outside of the Riksbank. For example, Fregert and Gustafsson (2008) describe the government as doing the following between the years 1715 and 1719. From 1715 to 1718, Karl XII paid for expenditures by issuing token copper coins that were stamped as having a value much greater than the metallic value. He also issued his own paper currency. Initially, Karl XII had promised to redeem these token copper coins for copper coins of the full metallic content at some degree in the future. However, both the token coins and the paper currency rapidly depreciated. In 1719, the Riksdag offered to exchange the token coins, which were denominated as 1 daler silvermynt, for 2 öre and a promissory note for 14 öre to be paid at some future unspecified date. Since 1 daler silvermynt was actually equal to 32 öre, this represented a significant devaluation. Nonetheless, Fregert and Gustafsson (2014) estimate that the amount of promissory notes issued by the government was about 1.6 times as large as the total debt owed to the Riksbank in 1719. Thus, the Riksbank debt actually significantly understates the amount of government expenditures precisely at the times which the Swedes were losing battles. I would therefore argue that the combination of the fact that (a) the government loan-to-deposit ratio is negatively correlated with battles won, (b) the historical accounts of the Battle of Poltava describe a Swedish army that is starving and short on supplies subsequent to the Riksbank inability to completely provide the funding requested by Karl XII, and (c) the subsequent period was one in which Karl XII desperately sought alternative means of financing, all point to the idea that the constraint on government borrowing was binding consistent with Predictions 1 and 2 described above. In addition, the binding constraint seemed to play an important role in Sweden’s defeat and therefore the decline as an imperial power. To conclude the discussion at this point would be premature since Sweden made attempts to recover the territory that had been lost in two subsequent wars. The first such attempt came during the Hats’ Russian War. As noted above, this was an attempt by the Hats to capitalize on a transition in power by the Russians. Contrary to the case during the Great Northern War, the Riksbank was permitted to issue bank notes. Lending by the Riksbank to the government was financed largely through the issuance of bank notes. The war was fought from 1741 to 1743 and the supply of bank notes nearly doubled over this period. As Prediction 3 details, evidence that the government borrowing constraint with the Riksbank became binding would imply that there was a dramatic decline in the reserve ratio over this period and followed by attempts to find other sources of financing. The ratio of reserves to total liabilities is shown in Fig. 5. As shown, the reserve ratio declined from nearly 25% at the end of 1739 to 7.5% at the end of 1743. The reserve ratio continued to decline until convertibility was abolished in 1745. Further evidence that this type of borrowing through the Riksbank was limited was the observation that the entire debt had been financed through the Riksbank (Fregert and Gustafsson, 2008), but that “attempts to borrow outside the Bank, domestically and abroad, were made in 1743 but they all failed (Fregert and Jonung, 1996, p. 451). Finally, in 1757, Sweden entered the Pomeranian War, a theatre of the Seven Years’ War. Sweden had entered the war because of a treaty they had signed with France. Sweden received subsidies from France, but they were not nearly enough to cover the war expenditures (Fregert and Jonung, 1996). The Riksbank was the primary source of funding for the war. Again, Sweden’s ability to finance an open-ended conflict depended on the ability of the Riksbank to expand its balance sheet in real terms. Since the bank was issuing inconvertible bank notes, the framework I described above implies that the relevant constraint on borrowing was the inflation rate. There was evidently some recognition of the limitations on the Riksbank in this regard because the government experimented with alternative methods of financing in addition to funding through the Riksbank. For example, Sweden used “lottery loans” in 1758 and 1759 to help finance the war (Fregert and Gustafsson (2008)). These loans consisted of selling lottery tickets to the public. Anyone holding a ticket was repaid at least 94% of the price of the ticket and a small fraction of ticket holders received large prizes. Overall, the lottery loans in 1758 amounted to a loan with an interest rate of approximately 10% from the general public. Like these lottery loans, however, all attempts to borrow outside of the bank were short-term (Fregert and Jonung, 1996). However, any desire to smooth taxation discussed above required long-term borrowing. By 1760, rising inflation and the corresponding depreciation of the exchange

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Fig. 6. Real value of assets on Riksbank balance sheet. Source: total assets: Fregert (2014). Price level: Edvinsson and Söderberg, 2010.

Fig. 7. Real bank note balances. Bank notes: Fregert (2014) and price level: Edvinsson and Söderberg, 2010.

rate caused the government to consider finding a source of financing outside of the bank (Fregert and Jonung, 1996, p. 454). The timing of this change is important. Fig. 6 plots the real size of the Riksbank balance sheet as measured by the real value of the total assets of the bank. By the end of 1760, the real value of the balance sheet had declined relative to the previous year and would continue to decline until 1765 when the Caps took over Parliament. The same pattern emerges in real bank note balances in Fig. 7. The reason that this result is important is as follows. In order for the Riksbank to provide funding for an open-ended military conflict, they need to expand the balance sheet. However, a nominal expansion of the balance sheet is not sufficient. What matters is the purchasing power of the new funding and therefore the balance sheet would need to expand in real terms. This is the fundamental idea of the conceptual framework in this section. During periods of convertibility, if the central bank finances loans through note issuance, the only way that the balance sheet can expand is if the public is willing to hold the additional bank notes. If there is an excess supply of bank notes, then these bank notes will return to the bank for redemption through the Law of Reflux (Glasner, 1989). Suspending or abolishing convertibility removes this reflux mechanism. However, this constraint is replaced by inflation. For example, the quantity theory implies that a one-time change in the money supply would have no long-run effect on income and interest rates. As a result, the price level would rise in proportion to the increase in the money supply to restore equilibrium (Friedman, 1956). However, a change in the growth rate of the money supply leads to higher inflation and therefore increases the opportunity cost of holding money. This reduces the demand for real money balances and therefore the price level rises by a larger percentage than the nominal money supply. This is shown in Fig. 3. Higher expected inflation therefore quickly undermines the ability of the central bank to be a significant source of financing for emergency military expenditures. This is the fundamental reason that central banks like the Bank of England were successful in financing military expenditures. They would suspend convertibility to eliminate the Law of Reflux as a constraint, but also promise to restore convertibility at the previous parity after the conflict was over. By doing so, they were promising that any inflation experienced during the war would be met by an equal deflation after

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Fig. 8. Bank notes and the price level. The dotted line is the actual data. The solid line is the best linear fit of the data. Source: Bank notes: Fregert (2014). Price level: Edvinsson and Söderberg, 2010.

the war. This kept long run inflation expectations anchored and thereby allowed for a real expansion of the bank’s balance sheet. Inflation expectations in Sweden were anchored to some extent by the fact that the Swedish government pledged future tax revenues as collateral for the loans from the Riksbank. In some sense, this is like a sinking fund in that the money printed to finance the loan will be taken out of circulation as the loan is repaid. Since the note issuance is expected to be temporary, this should keep inflation expectations anchored. Sylla and Wilson (1999) argue that sinking funds represented credible ways to achieve time consistency. Nonetheless, the anchoring of inflation expectations depends on the commitment. Hendrickson (2019), for example, demonstrates that imperfect commitment can lead to notes trading at a discount. If these discounts are interpreted as a sort of shadow value, then declines in the probability that the government will keep its commitment should result in a decline in real money balances. For a given money supply, this implies that a decline in the probability of commitment manifests itself in higher prices. Evidently, this sinking-fund-like commitment was initially seen as credible. From Figs. 7 and 8, there is a substantial increase in real money balances. However, after 1760 the price level starts rising faster than the money supply. This could be because the public did not anticipate that the Swedish government could meet its commitment to levy sufficient taxes in the future to repay the sinking fund or because the public believed that some amount of the already existing note expansion would be a permanent increase in the money supply, effectively monetizing some portion of the debt. As a result, the real size of the Riksbank balance sheet and real money balances decline, as shown in Figs 6 and 7. These observations, combined with the fact that the Swedish government was looking for alternatives to Riksbank financing in 1760, precisely when the reduction in real balances was the sharpest, are consistent with Prediction 4. Overall, the evidence suggests that the government faced binding borrowing constraints in all 3 wars. During the Great Northern War, the government reached its borrowing constraint at a critical juncture when they were short on supplies. As a result, they suffered a devastating military defeat from which they never recovered. This seems to suggest that the borrowing constraint was a cause-in-fact of the loss of the Great Northern War. In each of the other two wars, there is a lack of evidence that the borrowing constraints were a cause-in-fact of the defeats. Nonetheless, the evidence that these constraints were binding suggests that Sweden would not have been able to carry on these wars indefinitely. As such, the binding constraints can likely be considered a proximate cause of the military reversal of fortune. 4. Mercantilism, the quantity theory, and economic activity 4.1. A framework for analysis In 1739, the Riksbank liberalized its lending policy to allow for lending to private firms (Jonung, 1976, p. 42; Myhrman, 1976, p. 174). The Hats began an effort to encourage economic activity through loans and subsidies. Many firms were able to obtain credit directly from the Riksbank (Eagly, 1969, p. 748). This lending was largely financed through the issuance of bank notes (Edvinsson and Ögren, 2014). The opposition party, the Caps, were opposed to this policy for two reasons. First, the Caps objected to the lending on the grounds that it mainly helped “vested interests – privileged parties who had been granted large bank loans to build factories, or granted special franchises in foreign trade” (Eagly, 1969, p. 751). Second, and perhaps most importantly, the Caps argued that the expansion of note issuance was inflationary. The Caps were firmly committed to this second view as evident by the fact that they instituted a deflationary policy upon entering power in 1765. Determining whether the lending policy of the Hats was inflationary is straightforward. The Hats denied that their policy caused inflation. They blamed inflation on deficits in the balance of payments. As Myhrman (1976) notes, the combination of

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attitudes about policy and the action taken by each party makes this period of Swedish history something akin to a natural experiment. For example, the fact that the increase in the supply of bank notes was undertaken by the Hats to promote economic activity and the fact that the Hats denied that the supply of bank notes had any effect on the price level suggests that one can treat the supply of bank notes as exogenous with respect to the price level. Subsequently, when the Caps take over power, they deliberately reduced the supply of bank notes with the objective of reducing the price level. Given the deliberate policy actions taken by both the Hats and the Caps, I follow Myhrman (1976) in treating these policies as a natural experiment.12 By treating the supply of bank notes as exogenous, I can compare the supply of bank notes with the price level to determine whether any sort of quantity-theoretic relationship is evident in the data. Fig. 8 plots the relationship between the supply of bank notes and the price level in the era of inconvertibility. As evident in the figure, there is a clear and consistent positive relationship between the supply of bank notes and the price level as the quantity theory of money would predict. Since the Hats deliberately increased the supply of bank notes as part of their policy and denied that the supply of bank notes was a source of inflation, it is hard to make an argument consistent with reverse causation. Furthermore, note that at the point when the Caps take power in 1765, the line immediately bends backwards and re-traces its steps just as the quantity theory would predict. What remains to be considered is whether the Hats’ lending policies had the intended effect on economic activity. To do so, I consider 3 mechanisms through which the policies might have influenced economic activity. The first mechanism is through the lending itself. According to this view, a greater provision of loans could be seen as evidence of investment that otherwise would not have taken place and therefore greater capital accumulation and higher output. The second mechanism that I consider is the supply of bank notes. This mechanism implies that there is a distinct effect on economic activity from paper money creation. If indeed there was a shortage of money, then an increase in the supply of bank notes might increase economic activity. The third mechanism that I consider is the inflation rate. The choice of the inflation rate as a mechanism through which the Hats’ policy affected economic activity requires a bit more elaboration. The monetary framework that one should use to consider the effects of inflation depends on the monetary regime. The reason is that the price level is determined by the supply of and demand for the medium of account. Under a commodity standard, the commodity is the medium of account. To understand this point, consider the following example. Suppose that bank notes were denominated in dalers and that one daler was defined to be equal to one ounce of copper. This implies that the price of an ounce of copper is one daler. Arbitrage will ensure that the price of copper does not deviate from this definition. For all intents and purposes, the price of copper is fixed by the definition of the daler. An increase in the demand for (or reduction in the supply of) copper would normally increase the relative price of copper. However, since the price of copper is fixed, all other prices must decline in order for the relative price of copper to rise.13 In an inconvertible paper money standard, the bank notes themselves are the medium of account. As a result, the supply and demand for bank notes will pin down the price level. To understand why, consider the differences in regimes. Under a commodity regime, if the supply of bank notes exceeds the demand for bank notes, then individuals have an incentive to present these notes at the bank for redemption. There is no effect on the price level. By contrast, in an inconvertible paper money regime, an excess supply of bank notes cannot be presented for redemption. As a result, individuals will try to reduce money balances by buying other assets and/or goods and services. This process will continue until the price level sufficiently rises to the point at which the real value of existing nominal balances is equal to desired real money balances (Friedman, 1956). In an inconvertible paper money regime, the effects of inflation on output depend on whether inflation is anticipated or unanticipated.14 When inflation is unanticipated, output increases in response to higher inflation. However, when inflation is anticipated, it acts as a tax on money balances (Kessel and Armen Alchian, 1962; Friedman, 1969). This causes individuals to economize on money balances thereby increasing the costs of transactions and ultimately reducing equilibrium output. Since inflation was a public concern during the Hats’ long term in power and after convertibility was abolished (Eagly, 1969), I hypothesize that inflation had a negative effect on output during this period. Nonetheless, since I estimate each model using the longest sample possible, this requires a non-linear specification with regards to the monetary regime. 4.2. Empirical analysis In this section, I examine the effects of private lending, the supply of bank notes, and the inflation rate on real GDP per capita in Sweden for the period between 1668 and 1772 using Jordá’s (2005) local projection method. The choice of this methodology is due to the combination of limited data and the flexibility of this framework for dealing with non-linear relationships. The available data for this period are annual and therefore pose sample size problems if the analysis is limited

12 Herger (2018) does not treat this as a natural experiment and instead estimates the effects of bank notes on inflation and the exchange rate in a structural vector autoregression model. He finds evidence that the increased supply of bank notes did lead to higher inflation and a depreciation in the exchange rate. 13 The relevant theoretical framework to apply to a commodity standard is the classical model of money. This is perhaps best articulated by Thompson (1974) and Glasner (1985; 1989, Ch. 3). However, see also Barro (1979b), Niehans (1979, Ch. 8) and Sumner (2015, Ch. 1) for a similar view of how the price level is determined in a commodity standard. 14 This is the point emphasized by Friedman (1968) and Lucas (1972), among others. For an excellent textbook treatment of this issue, see Champ et al. (2011).

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Fig. 9. Response of real GDP per capita to Private Lending.

to the period of time in which the Hats are in power. By using a non-linear model specification, I can allow for the effects of a particular variable to differ between regimes and expand the sample size. I estimate each model using annual data from 1668 to 1772. The data on real GDP per capita are from Schön and Krantz (2012). The data on private and public lending and bank notes by the Riksbank are taken from the Riksbank balance sheet data produced by Fregert (2014). Since the data are end-of-period values, I construct average values by taking the average of the end-of-year value for the current year and that of the previous year. Since the data on bank notes were prohibited by the Riksbank, they do not appear on the Riksbank balance sheet until 1710 when transportation notes appear on the balance sheet. The magnitude of bank notes are therefore quite small until the 1720s when transportation notes became something more equivalent to modern bank notes and acceptable for tax payments (Edvinsson and Ögren, 2014). Finally, inflation is calculated by the log-difference in the deflator series in Edvinsson and Söderberg (2010). 4.2.1. The effect of private lending on real GDP per capita To examine the effects of private lending on real GDP per capita, I estimate h regressions of the form:

ln yt+h =

α + Xt  + βh ln Privt +

J 

γh,j ln Privt−j +

j=1

+ Dt



βd,h ln Privt +

J 

J 

θh,j ln Publict−j +

j=1

γd,h, j ln Privt− j +

J 

j=1

θd,h, j ln Publict− j +

j=1

J 

ωh,j ln yt−j

j=1 J 

 ωd,h, j ln yt− j + εt+h

(1)

j=1

where y is real GDP per capita, X is a matrix of war dummies, Priv is private lending from the Riksbank, Public is Riksbank lending to government, D is a dummy variable that takes on the value of unity during periods of convertibility, ε is an error term, and h ≥ 0. Here, βˆh is an estimate of the effect of private lending done by the Riksbank on real GDP per capital h periods ahead during periods of inconvertibility. I estimate the regression for h = 0, 1, . . . , 4, J = 1, and plot the corresponding impulse response function in Fig. 9.15 The dotted lines in the figure are the 95% confidence interval associated with Newey–West standard errors. As shown in Fig. 9, the effect of private lending on real GDP is negative, but not statistically significant with the exception of marginal significance one period ahead. Eagly (1969) argues that the Hats saw this type of lending as a way to promote economic activity and development. The Caps, in contrast, argued that the such lending was designed to benefit particular constituencies and not promote economic activity more generally. The results presented in Fig. 9 suggest that there is no evidence that these lending policies had any effect on economic activity. 4.2.2. The effect of the supply of bank notes on real GDP per capita To examine the effects of the supply of bank notes on real GDP per capita, I estimate h regressions of the form:

ln yt+h =

α + Xt  + βh ln Nt +

J 

γh,j ln Nt−j +

j=1

+ Dt



βd,h ln Nt +

J  j=1

15

γd,h, j ln Nt− j +

J 

ωh,j ln yt−j

j=1 J 

 ωd,h, j ln yt− j + εt+h

j=1

The results here and in the subsequent section are robust to a choice of J = 2.

(2)

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Fig. 10. Response of real GDP per capita to the supply of bank notes.

where y is real GDP per capita, X is a matrix of war dummies, N is the supply of bank notes, D is a dummy variable that takes on the value of unity during periods of convertibility, ε is an error term, and h ≥ 0. I estimate the regression for h = 0, 1, . . . , 4 and J = 1. The estimate, βˆh , is an estimate of the magnitude of the effect of bank notes on real GDP per capita h periods ahead during the period of inconvertibility. The estimated impulse response functions are plotted in Fig. 10. Again, the dotted lines denote the 95% confidence interval using Newey-West standard errors. Eagly (1969) argues that the Hats saw a permanent relationship between the supply of bank notes and output. However, as I noted, it is not clear whether this is correct or whether the Hats were simply worried about a shortage of money, which is a more accurate view of mercantilist ideology. Regardless of the interpretation of the Hats, there is no evidence of an effect of bank notes on real GDP per capita. 4.2.3. The effect of inflation on real GDP per capita Finally, to determine the effects of inflation on real GDP per capita during periods of inconvertibility, I estimate h regressions of the form:

ln yt+h =

α + Xt  + βh ln πt +

J 

γh,j ln πt−j +

j=1

+ Dt



βd,h ln πt +

J  j=1

γd,h, j ln πt− j +

J 

ωh,j ln yt−j

j=1 J 

 ωd,h, j ln yt− j + εt+h

(3)

j=1

where y is real GDP per capita, X is a matrix of war dummies, π is the inflation rate, D is a dummy variable that takes on the value of unity during periods of convertibility, ε is an error term, and h ≥ 0. I estimate the regression for h = 0, 1, . . . , 4 and J = 1. The estimate, βˆh , measures the magnitude of the effect of inflation on real GDP per capita h periods ahead during the period of inconvertibility. The estimate, βˆd,h , measures the magnitude of the effect of inflation on real GDP per capita during the period of convertibility. The impulse response function for the effect of inflation on real GDP per capita during the period of inconvertibility and convertibility is shown in Fig. 11. As shown in Fig. 11, inflation has a negative and statistically significant effect on real GDP per capita during the period of inconvertibility. The largest effect is one period ahead in which a one percent increase in inflation leads to an estimated reduction in real GDP per capita of 0.52%. Back of the envelope calculations suggest that inflation resulted in an average decline in real GDP per capita of between 2.2% and 2.8% per year over this period relative to the counterfactual. This implies that Hat policies had a negative and sizable effect on real economic activity. 4.2.4. The effect of the Hats’ policy on output Overall, these results suggest that the policies implemented by the Hats after the abolition of convertibility were not only unsuccessful in promoting economic activity, but were actually detrimental. Regardless of whether one interprets the Hats as being concerned with a money shortage or believing that there is a permanent and positive relationship between money and output, the empirical results indicate a negative relationship between the supply of bank notes and output, albeit not statistically significant. Furthermore, I failed to find evidence that the lending policies of the Hats had any effect on output. What is evident in the empirical analysis is that there appears to be a strong relationship between the supply of bank notes and the price level. This is consistent with the view of the Caps, who argued that the observed inflation was due to an excess supply of bank notes. In addition, inflation had a negative and statistically significant effect on output during the

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Fig. 11. Response of real GDP per capita to Inflation Under Inconvertible Paper Money.

period of inconvertibility. The results show that the Hats’ inflationary policies contributed to the decline in real GDP per capita during their time in power. Thus, it seems reasonable to assert that Hat policy contributed at least to some degree to Sweden’s reversal of economic fortune. 5. Conclusion After a century of sustained economic growth and amassing an empire that covered much of the area surrounding the Baltic Sea, Sweden experienced a century long reversal of fortune in the 18th century. In this paper, I have attempted to provide a framework and evidence to explain the reversal in both military and economic fortunes. I put forth two hypotheses each related to the early Riksbank. Regarding the military reversal, I argue that government borrowing constraints, including the rules that governed the Riksbank, left Sweden unable to provide open-ended financing for war. This is especially evident during the Great Northern War. When the government reached its borrowing limit at the Riksbank, the Swedish army was short on supplies. The inability to increase government borrowing turned out to be crucial since shortly thereafter Sweden lost what turned out to be the decisive battle in the war in large part because of the supply shortages. Subsequent attempts were made to recover the land that was lost in the Great Northern War, but these attempts were unsuccessful. In these later conflicts, there is evidence that the government faced binding borrowing constraints as well. The economic reversal of fortune coincides with the loss in the Great Northern War and the subsequent “Age of Freedom.” It is during this latter period that the Hat Party in Sweden experimented with using the central bank to promote economic activity. The Hats’ objective was to use the Riksbank to provide the necessary finance to promote economic activity. These private loans were made possible by expanding the issuance of bank notes. I propose three ways in which this policy could have had an effect on economic activity: (a) through the lending itself, (b) by alleviating a money shortage, or (c) through the resulting inflation. I find no evidence that the lending or the supply of bank notes had a direct effect on real GDP per capita. In addition, I find that inflation led to a reduction in real GDP per capita that is both economically and statistically significant. Given the dramatic increase in inflation over this period, it is possible that the economic reversal of fortune – at least that which occurred during Frihetstiden – can mainly be attributed to the adverse effect of the Hats’ lending policy. Some additional points deserve some consideration. First, it should be re-stated that the Riksbank was not set up to explicitly finance war. Nonetheless, it found itself in this role in part because of the limited fiscal capacity of Sweden and later because of the effective consolidation of monetary and fiscal policy during Frihetstiden. I believe that the evidence that I presented in this paper demonstrates that the Riksbank was ill-equipped for this role and that this failure is a proximate cause, if not the cause-in-fact, of the reversal of fortune with respect to the empire. Second, it is not clear how much of the blame that the Riksbank deserves for the economic reversal. In looking at Fig. 1, the reversal of economic fortune begins at the start of the Great Northern War and real GDP per capita had declined quite dramatically by the end of the war. However, one must be careful with the counterfactual. For example, it is possible that Sweden would have recovered if not for the policies of the Hats. The average annual declines in real GDP per capita that resulted from the inflationary Hat policies are large enough to have a significant cumulative effect over this period. It is important to note, however, that these results should be qualified with the notion that there is likely significant measurement error in the data. One should therefore use caution when reasoning from specific point estimates. More speculatively, it could be the case that the decline in both the empire and real GDP per capita share the same cause. Thompson (1974) and Thompson and Hickson (2001) argue that fiscal policies and institutions evolved to finance adequate national defense and that capital (and wealth) accumulation is limited by the ability to provide adequate defense.

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Hendrickson et al. (2018) extend this logic further and argue that if the ability to provide adequate defense is a constraint on capital accumulation, then military technology is a long-run driver of economic growth. Within the context of this literature, Sweden’s reversal of military and economic fortune might be tied to the inability of Sweden to provide adequate national defense as a result of limited fiscal capacity and a central bank ill-equipped to finance open-ended conflicts. In other words, Sweden’s limited state capacity and inability to provide adequate emergency financing might have been a constraint on economic output. Whether or not this latter hypothesis is true is a potential avenue for future research because it requires a more systematic treatment of these types of episodes. On this note, I hope that this paper will encourage others to examine both military and economic reversals within a similar context. 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